Be it interest rate concerns or talk of a bond bubble, the high yield market has faced a step back over the past couple weeks. We’ve addressed the interest rate concerns at length—see our piece “Strategies for Investing in a Rising Rate Environment” and blog “Is This Time Different?”—and at the end of the day, history would indicate that high yield bonds have historically performed well during a rising rate environment.
Turing to the bond “bubble” talk, let’s look at the 2005-2007 period when we really did see concerning conditions in the high yield bond market. Looking at the Credit Suisse High Yield Index as a proxy for the market, we saw spreads break 400bps in July 2005 and stay under this level until bottoming out at 271 bps in May 2007.1 This is a far cry off of the spread of 475bps that we sit at today.2 And while concerns have recently been raised about loosening underwriting standards and a pick-up in “covenant lite” activity in the loan world, we certainly aren’t seeing the lack of discipline across the board as we saw in 2005-2007, where deals were getting down at massive multiples (many of which have since proved unstainable) and we saw telling signs like an abundance of PIK (pay-in kind versus cash interest pay) and dividend deals. Over recent years, market issuance has been dominated by refinancing rather than this sort of activity and transaction multiples for M&A have been relatively tame. So, this isn’t 2007 and we don’t see conditions that warrant labeling the high yield market a “bubble” that should be avoided. If anything, the volatility that we have seen over the past few months speaks to rationality—markets can’t continually go up and we would see a periodic step back as healthy.
We’ve heard lots of other reasons why we are seeing sellers in the market, and there seems to be some inconsistencies in some of these reasons. I’ve heard the concern that if rates do rise, that could lead to a set-up in defaults. A couple things to keep in mind: generally we see rates rising during periods of stronger economic activity. We would think that for a substantial rise in rates to happen, we would need to see the economy improve off of where we are today. That doesn’t mean that we won’t still potentially see the Fed take short term rates up little next year at some point, but we would expect that for this Fed to make a big move, they would certainly need to see improved economic conditions, especially in areas such as unemployment and underemployment. And on the flip side, if those strong economic conditions are there by mid-2015 and beyond, then that is a benefit to corporate credit as we would presumably see improved financial prospects for these companies…and one would then think improving financial prospects would in turn equate to lower defaults.
Maybe this is an obvious statement, but the other thing to note as we think about defaults is that higher rates don’t necessarily mean that costs get more expensive for high yield bonds issuers—high yield bonds are fixed rate securities and the fact that so much of the market has refinanced bonds over the past few years and locked in low rates (saving on interest costs) positions them well to manage through the environment ahead. And with the fixed coupon on these securities, that helps keep free cash flow cash generation steady.
On the flip side, potentially higher interest rates mean that companies needing to refinance would face likely higher rates to do so—but again, we don’t see a massive spike in rates on the horizon so that could well mitigate this issue. Additionally, it is important to keep in mind the amount of bond maturities over the coming years. As you can see from the chart below, of the $1.6 trillion market, we only have a very small portion maturing between now and 2018/2019 when maturities start to pick up, so this bodes well for any sort of refinancing risk in the near-term as we seemingly have years of runway.3
Turning to another issue we have seen mentioned several times over the past week or two: concerns are being raised that companies are focusing on more shareholder friendly activities, such as using cash for stock buybacks. While yes, that can be an issue, there are other caveats to consider. For instance, while we never like to see cash go out the door for stock buybacks or dividends, we often see this occurring in companies that are generating good cash flow that they want to do something with—and free cash flow generation is virtually always a positive. As a bond holder, it is also important to keep in mind that these sorts of equity-focused actions can easily be turned off should that cash flow be threatened. Additionally, active managers can avoid the credits where the company is levering up to unsustainable levels or using cash they don’t have to spend to fund these shareholder friendly activities.
Finally, some also attribute the recent selling pressure in the high yield market to global weakness and a general risk-off trade. Also mentioned are certain industries under severe pressure. This seems more of a rationale argument, as we can’t deny that we are certainly seeing economic weakness in certain areas of Asia and Europe, not to mention the issues in the Middle East, Russia, and Western Africa. But we argue this is why we view active management as so essential. Active managers can avoid names that would have large exposures to these areas facing weak economic activity or other geopolitical issues, and focused more on North American-focused companies, which makes up the predominant portion of the high yield space. And active management is equally important in assessing industries under pressure. Our experience has been that industries facing challenges can actually create opportunities for active managers that can parse out the strong players that they view as undervalued and likely destined to benefit from a change in the competitive landscape, from the weak players that are likely destined for failure.
At the end of the day, we don’t see a sizable interest rate hike on the horizon unless we were to see a strong recovery in the economy, and if that is the case then we believe high yield corporate credit stands to benefit from the improved economy and has historically managed rising rates well (again see our piece “Strategies for Investing in a Rising Rate Environment” for historical data points and further detail). Certainly we don’t see a rising rate scenario as an automatic trigger for defaults to quickly spike—defaults generally increase during times of systemic issues, which we don’t see on the horizon, not to mention the forward maturity schedule is very manageable. We feel that the recent selling pressure creates an even better entry point in terms of purchasing credits and can help to increase potential yield and capital gain generation for investors.
1 The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
2 The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. Level as of 9/25/14.
3 High yield market size of $1,588 billion, Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. June 27, 2014, p. 5.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.